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June 7, 2013

Asset Class Correlation Hits New High

Even as it hits alpha, correlation might itself turn into an asset class, research firm says

In what is sure to please alternative investment providers, a study released Thursday by CRISIL Global Research & Analytics, based in Mumbai, India, shows that there has been an “accentuated” correlation among traditional asset classes over the past five years when compared with any period before 2008.

The study notes the increase in correlation has also been accompanied by lower returns, thus giving cause for concern to global fund managers. Around 88% of respondents to the survey indicated that correlation was now among the top five investment risk factors, and 65% believed that correlation was causing a “material negative impact on the availability of alpha-generating opportunities.”

“Our survey shows a structural uptrend in correlation with low possibility of returning to historical levels, supported by globalization and financialization of assets,” V. Srinivasan, senior director of CRISIL GR&A, said in a statement. “This will have two implications for financial research. First, research will get further streamlined; second, we will see more investments in high-end research to capture alpha.”

According to the firm’s analysis of 33 assets and 528 pairs of correlation from 1998 to 2012, the proportion of asset classes with correlation level above 0.3 has risen from 31% to 58% between 1998-2002 and 2008-2012. This increase in correlation is particularly pronounced during the last five years, the study adds.

It notes a “material increase in correlation across all dimensions, a corresponding drop in opportunities for securing benchmark-beating returns and a reduction in the level of outperformance.”

At a more granular level, it explains, this increase is more pronounced within equities, leading to a reduction in the extent of outperformance. The equity correlation across various pairs has increased from 0.6 during 1998-2002 to a relatively steep 0.86 during 2008-2012.

This has prompted investors to pursue noncorrelated assets. However, even assets that have been historically low on correlation are now seeing a rise in correlation with their returns converging. For instance, returns from multiasset funds, which tend to invest in alternative asset classes, have converged with the MSCI World Index, an equity index.

“We see this becoming a trend,” Suresh Krishnamurthy, director of CRISIL GR&A, added. “As newer, noncorrelated assets emerge, we see them eventually getting correlated and offering lower alpha potential over time. This calls for a healthy pipeline of new-age alternative assets to emerge.”

Even as correlation has emerged as a key risk factor, CRISIL GR&A believes it will soon develop into an investable asset class of its own, similar to the way in which volatility has transformed from a risk factor to an asset class. The signs are already visible, as seen in the CRISIL GR&A survey, which was conducted with global fund managers spread across Americas (60%), Europe (33%) and Asia (7%).